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Managing risk in volatile markets

During periods of significant volatility in the markets, for instance around a big FOMC announcement, many traders doubt their own risk management techniques. The question remains: have we really moved beyond the events of 2008, and do we truly understand volatility and the accompanying risk?

Quantifying uncertain events

For years, traders have used statistical models to try and predict future market movements. These models mostly rely on the fact that events tend to show a ‘normal’ distribution: within any given 24-hour timeframe, the probability that the price of a trading instrument will move up or down by a given amount can usually be fairly accurately calculated.

Over the last decade the accuracy of many of these statistical models has come into question. We often see events that are ‘supposed’ to happen no more than once every fifty years actually occur twice over the course of a few months.

The future has proved much less predictable than we first thought. In this truth lies the reason why so many traders lost such a lot of money during events such as 9/11 and the financial meltdown of 2008. If our trading systems more fully incorporated the realities of an uncertain market and we had plans in place to react to these events, most traders would have survived them far better.

So where does this leave the ordinary trader?

Risk management techniques

Serious doubt has been cast on many of our risk management techniques for their inability to properly deal with so-called ‘black swan’ events – events that are extremely rare and unexpected but which, when looking back, often seem totally predictable. An example often quoted is the mortgage meltdown. How is it possible that we missed all the obvious signs and allowed such an event to wipe trillions off the balance sheets of private and corporate investors?

Risk is the possibility of losing money. In any given trade there is the possibility that you might lose part or all of your investment. How much you are prepared to risk depends on your individual risk appetite and the potential profits involved. If you could double your money with a given trade, you might be prepared to risk a significant percentage of your capital on that trade. If you only stand to make a 10% profit, your risk levels should be downsized accordingly, otherwise you face the possibility of wiping out your trading account.

Risk management is simply the practice of assessing the level of risk and then taking steps to minimise this level, taking into account the potential return and your risk appetite.

A Stop Loss is one way to make sure you never lose more than you can afford. This is a request to close your position at a certain price worse than your opening price, to prevent you from making further losses. You should note however that Stop Losses are not guaranteed and may be subject to slippage (positive or negative) and market gaps in volatile market conditions.

Your position sizing is another important risk management tool. A simple technique is to start with a certain number of contracts and buy an additional contract for every x number of points the price increases, or sell off contracts if the price decreases by the same amount. Such a system can be designed to be profitable even if the trader happens to be wrong about the direction of the market two out of three times.

The importance of following your trading plan cannot be overemphasised. If a black swan event should happen today, closely following your trading plan could make the difference between being wiped out or surviving until another day.

Hedging is a time-honoured way of protecting yourself against a volatile market. If you are significantly long of gold, for example, you can open a small short position in gold to guard against the potential loss of a black swan event. Also, if there is a proven correlation between gold and the price of another commodity, you can use cross-asset hedging to protect your portfolio.

Managing your capital across your portfolio

Portfolio management is also very important when it comes to minimising risk. Novice traders often make the mistake of investing all they have in a ‘hot’ share, only to be proved wrong and wiping out their trading account. A well-balanced portfolio might not double your money every seven days, but it will help you to protect your capital – which is vital for any trader.

Remember, the decision-making process in risk management is two-fold: first, identify and quantify the level of risk levels as well as you can, then draw up a trading plan consistent with these risk levels and taking into account your investment goals.

Published: 14 December 2015

You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.

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